My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Monday, February 6, 2017

January 2017 Data Update 9: Dividends and Buybacks

If you are from my generation, I am sure that you remember Rodney Dangerfield, whose comedy routine was built around the fact that "he got no respect". This post is about dividends and cash return, the Rodney Dangerfield of Corporate finance, a decision that gets no respect and very little serious attention from either academics or practitioners. In many companies, the decision of how much to pay on dividends is made either on auto pilot or on a me-too basis, which is surprising, since just as a farmer’s payoff from planting crops comes from the harvest, an investor’s payoff from investing should come from cash flows being returned. The investment decisions get the glory, the financing decisions get in the news but the dividend decisions are what complete the cycle.The Dividend Decision
The decision of whether to return cash to the owners of a business and if yes, in what form, is the dividend decision. Since these cash flows are to equity investors, who are the residual claim holders in a business, logically, the dividend decision should be determined by and come after the investment and financing decisions made by a business. The picture below captures how dividends would be set, if they were truly residual cash flows:

The process, which mirrors what you see in a statement of cash flows, starts with the cash flow to equity from operations, computed by adding back non-cash charges (depreciation and amortization) to net income. From that cash flow, the firm decides how much to reinvest in short term assets (working capital) and long term assets (capital expenditures), supplementing these cash flows with debt issuances and depleting them with debt repayments. If there is any cash flow left over after these actions, and there is not guarantee that there will be, that cash flow is my estimate of potential dividend or if you prefer a buzzier word, the free cash flow to equity. With this free cash flow to equity, the firm can do one of three things: hold the cash (increasing its cash balance), pay a dividend or buy back stock. To the right of the picture, I use a structure that I find useful in corporate finance, which is the corporate life cycle, to illustrate how these numbers change as a company ages.

Early in a company’s life, the operating cash flows are often negative (as the company lose money) and the hole gets deeper as the company has to reinvest to generate future growth and is unable to borrow money. Since the potential dividends (FCFE) are big negative numbers, the company will be raising new equity rather than returning cash.

As the company starts to grow, the earnings first turn positive but the large reinvestment needs to sustain future growth will continue to keep potential dividends negative, thus justifying a no-cash return policy still.

As the company matures, there will be two developments: the operating cash flows to equity will start exceeding reinvestment needs and the company’s capacity to borrow money will open up. While the initial response of the company to these developments will be denial (about no longer being growth companies), you cannot hide from the truth. The cash balance will mount and the company’s capacity to borrow money will be increasingly obvious and pressure will build on it to return some of its cash and borrow money.

Even the most resistant firms will eventually capitulate and they will enter the period of plentiful cash returns, with large dividends supplemented by stock buybacks, at least partially funded by debt.

Finally, you arrive at that most depressing phase of the corporate life cycle, decline, when reinvestment is replaced with divestitures (shrinking the firm and increasing free cash flows to equity) and the cash return swells. The company, in a sense, is partially liquidating itself over time.

The truth is that there are companies where the decision on how much to pay in dividends in not the final one but the one made first. Put differently, rather than making investment and financing decisions first, based upon what works best for the firm, and paying the residual cash flow as dividends, firms make their dividend decisions (and I include buybacks in dividends) first and then modify their financing and investing decisions, given the dividends.

The companies that follow this backward sequence, and there are a lot of them, can easily end up with severely dysfunctional dividend policies that can destroy them, unless good sense prevails. It is an attitude that was best captured by Andrew Mackenzie, CEO of BHP Billiton, who when analysts asked him in 2015 whether he planned to cut dividends, as commodity prices plummeted and earnings dropped, responded by saying "over my dead body".

Dividends, Cash Return and Potential Dividends: The US History

Let’s start with some history on dividends, using the US market. In the graph below, I start by providing the basis for my inertia theory of dividends by looking at the proportion of US firms each year that increase dividends, decrease dividends and leave dividends unchanged:

In every year, since 1988, far more firms left dividends untouched than increased or decreased them, and when dividends did get changed, they were far more likely to be increased than decreased.

Let’s follow with another fact about US companies. Increasingly, they are replacing dividends, the time-tested way of returning cash to stockholders, with stock buybacks, as you can see in the figure below, where I graph dividends and stock buybacks from the S&P 500 companies from 1988 to 2016.

The shift is remarkable. In 1988, almost 70% of all cash returned to stockholders took the form of dividends and by 2016, close to 60% of all cash returned took the form of buybacks. I have written about why this shift has occurred in this post and also why much of the breast beating you hear about how buybacks represent the end of the economy is misdirected. That said, the amount of cash that US companies are returning to stockholders is unsustainable, given the earnings and expectations of growth. In the figure below, I look at for the S&P 500, the cash returned to investors as a proportion of earnings each year from 2001 to 2016:

Having looked at US companies, let’s turn the focus to the rest of the world. The stickiness of dividends that we see in the United States is a global phenomenon, though it takes different forms in some parts of the world; in Latin America, for instance, it is payout ratios, not absolute dividends, that companies try to maintain. To provide a measure of cash returned, I report on three statistics:

Cash Return Statistic

Definition

What it measures

Dividend Yield

Dividends/Market Cap

Portion of equity return that comes from dividends.

Dividend Payout

Dividends/Net Income (if net income is positive, NA if negative)

Proportion of earnings held back by the company for reinvestment or as cash balance.

Cash Return/FCFE

(Dividends + Buybacks)/FCFE (if FCFE is positive, NA if negative)

Percentage of potential dividends returned to stockholders. Remaining goes into cash balance.

The picture below looks at these dividend yields and payout ratios across the globe:

Unlike investment and debt policy, it is difficult to determine what number here would be the “best” number to see. Clearly, over time, you would like companies to return residual cash to stockholders but prudent companies, facing difficult business times, should try to hold back some cash as a buffer. Returning too little cash (low payout ratios) for long periods, though, is indicative of an absence of stockholder power and a sign that managers/insiders are building cash empires. Returning too much cash can mean less cash available for good projects and/or increasing debt ratios. In the table below, you can see the statistics broken down by region:

Let's take a look at the numbers in this table. The shift towards buybacks which has been so drastic in the United States seems to be wending its way globally. While there are markets like India, where buybacks are still uncommon (comprising only 6.36% of total cash returned), almost 30% of cash returned in Europe and 33% of cash returned in Japan took the form of buybacks. In Canada and Australia, companies returned over 150% of potential dividends to investors, perhaps because natural resource companies are hotbeds of dysfunctional dividend policy, with top managers maintaining dividends even in the face of sustained declines in commodity prices (and corporate earnings). The Mackenzie "over my dead body" dividend policy is live and well at many of other natural resource companies. With buybacks counted in, you see cash return rising above 100% for the US as well, backing up the point made earlier about unsustainable dividends.

Cash Return: A Company and Sector Comparison

Dividend policy varies across firms, the result of not only financial factors (where the company is in its life cycle, what type of business it is in and how investors get taxed) but also emotional ones (how risk averse managers are and how much they value control). As a result dividend yields and payout ratios vary widely across companies, and the picture below captures the distribution of both statistics across US and global companies:

There are wide variations in cash return across sectors, some reflecting where they stand in the life cycle and some just a function of history. In the table below, I highlight the sectors that returned the most cash, as a percent of net income, in the table below:

It is difficult to see a common theme here. You can see the residue of sticky dividends and inertia in the high cash return at oil and gas companies, perhaps still struggling to adapt to lower oil prices. There are surprises, with application software and biotech firms making the list. Looking at the sectors that returned the least cash, here is the list of the top ten:

If the cash that companies can return increases as they age, you should see the cash return policies change over time for sectors. Many of the technology firms that were high growth in the 1980s are now ageing and they are returning large amounts of cash to their stockholders; Apple, IBM and Microsoft are at the top of the list of companies that have bought back the most stock in the last decade.

Cash Balances

While this post has been about how much cash companies return to stockholders, the inverse of whatever is said about cash return can be said about cash retained in companies, which shows up as cash balances. In fact, if you use potential dividend (FCFE) as your measure of cash that can be returned and dividends plus buybacks as your measure of cash that is actually returned, your cash balance at any point in time for a publicly traded firm can be written as:

When companies accumulate large cash balances, it is never by accident but a direct consequence of having held back cash for long periods. So, how much cash do publicly traded companies hold? To answer that question for US companies, I look at a distribution of cash as a percent of firm value (market value of equity + total debt) in the figure below:

Thus, the median company in the United States at the start of 2017 held 2.45% of its value in cash; remember that with the US tax code’s strictures on foreign income being taxed on repatriation, a significant portion of this cash may be beyond the reach of stockholders, at least for the moment. The median company globally holds 5.50% of value in cash, with small differences across regions with one exception. Japan is the outlier, with the median company holding 22.24% of its value in cash. Expanding the comparison globally, I look at cash as a percent of firm value by country in the picture below:

Note that, as with dividend payout, it is difficult to decide what to make of a large (or a small) cash holding. Thus, large cash balances may provide a buffer against bad times, but they may also indicative of poor corporate governance, where stockholders are powerless while manager accumulate cash.

Conclusion

Since equity is a residual claim, it has never made sense to me that companies commit to paying a fixed dividend every year. I know that this is how dividend policy has been set since the beginning of equity markets, but that reflects the fact that stocks, when first traded, were viewed as bonds with price appreciation, with dividends standing in for coupons. As companies increasingly face global competition and much more uncertainty about future earnings, their reluctance to increase dividend commitments is understandable. If you buy into my characterization of dividends as analogous to getting married and buybacks as the equivalent of hooking up, companies and investors are both choosing to hook up, and who can blame them?

8 comments:

Great post professor! I especially liked the ending on the explanation of early equity markets, very interesting. Also, any chance you will be attending the FMA conference in March in NY, NY? I would love for you to sign my copy of The Little Book of Valuation if you're there!

Mike,I don't think I will be there. I have a cray busy semester with two very big classes. I am sure that we will run into each other or if you are close to NYU, drop by. I will be glad to sign it for you.

Policymakers are wrestling with how to tax corporations. The effective tax rate varies dramatically by industry in the US, and multinationals are good at evasion through foreign tax havens. That should be distorting the tax burden, employment, savings rates, and therefore probably yields, and economic growth.

It seems much simpler if we dropped the corporate tax entirely, but taxed dividends and capital gains as ordinary income. If the owner of a US stock is foreign, then their holding are still taxed. In order to reduce the preference for choosing capital gains over dividend payments in order to forestall shareholder tax payments, corporations would have to pay a tax on buybacks and savings that exceed some threshold (maybe the greater of % of value or % of capital investments).

That seems to me more straightforward than either current corporate tax policy, or the proposed border adjustment tax plan. Why wouldn't it work?

Just a quick high-level question - how are you computing share buybacks for the market and/or sectors/industries? Tried to go through some of your data sets, but the $ amount of buybacks for any given year seem to be hard-coded.

How do you parce-out buybacks vs. new share issues vs. stock comp etc. and the price at which shares were bought back (from a higher-level, market/industry perspective)?

Hi teacher. What is your advise on a company that is mature, almost declining but needs to make large investments to update their technology and products in order to survive. It is a family owned busines where the stockholders need the dividend for their personal needs and are not willing to make reinvestments on the small cash available. Thank you

Hi Professor - In the opening paragraph, you say that "the decision of how much to pay on dividends is made either on auto pilot or on a me-too basis." What do you mean by a me-too basis? Thanks for your clarification.

Having read a lot of your articles & classes, I am sure this is a good one (I just glanced at it now - will read fully soon). But the bottom line question is "however decisions are made - on auto pilot or on a me-too basis" - what is the long term (10-20y) total return to the investors from companies returning capital to investors vs those who do not. Seems like the "forced discipline" stops companies from stupid decisions (such as Cisco in the late 90s).

On a side note, the country comparisons is fairly meaningless as there are so many differences as to make it wholly irrelevant. The sector one is much more useful.